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Active vs. Passive Management

Date : 27/02/2017

Author:  Talal Al-Othman

Blog - Active vs. Passive Management

For the past few decades, one of the most debated topics in finance has been the argument of:
Which strategy is better, Active or Passive Management?

Each side can make a strong logical case to support their arguments, yet no clear winner has emerged. So, which strategy is the better? Before we can answer that question, let’s explore how each strategy is defined along with their associated benefits and risks.

Active Management refers to a manager, or team of managers, actively trying to outperform a specific benchmark through the use of  analytical research, forecasts, and judgment in making investment decisions on what securities to buy, hold and sell. The majority of Mutual Funds are categorized as actively managed products.  Advantages of active management include: Flexibility; altering
the weights of their holdings against the outperforming/underperforming areas of their respective benchmark. Research; carrying out exhaustive research to identify which areas to invest in. Defensive Measures; minimizing potential risks by applying instruments such as shorts, options and swaps.

Ironically, some of the risks of active management are derived from the benefits they offer, such as: High Fees (cost of research), Style Limitations (long-short Funds in a rally), and Stock Picking Risk (choosing non-performers).


Both strategies should be treated as tools, not rules, to be utilized on a case-by-case basis, depending on risk appetite and market conditions


Passive Management is defined as a management approach based on investing in exactly the same securities, in the same proportions, as an index such as the S&P 500. It’s termed passive because managers don’t make decisions about which securities to buy and sell. Managers apply the same methodology of portfolio construction the index uses. Index Funds and ETFs are classified as passively managed investments. As implied in its definition, the benefits of passive management include Diversification, Simplicity, and Low Fees. The drawbacks of passive management involve Total Market Risk, Non-flexibility, and Limited Returns. Today, the industry has finally come to the realization that the answer to our original question is evident when the question is asked differently; “Which strategy is better for you, at this time?“ Traditionally, Active Management tends to do well during times of volatility, while Passive Management tends to outperform in the long run.

Therefore, both strategies should be treated as tools, not rules, to be utilized on a case-by-case basis, depending on the investor’s risk appetite and current market conditions. So, when asking a simple question of: “Which strategy is better?” The answer is also simple, both.

Cumulative fund flows


This article is published in "Engage Q4, 2016" - click to view the publication


 

Tags:  Business, Company Analysis

Ratings: 
   Current rating: 5 (2 ratings)

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